Explain to me the basic basics of the stock market

Factual Questions
1

I’m a biologist. I could talk for hours about what’s going on at the molecular level during meiosis I in fruit fly ovaries. In fact, I’m writing this while I should be writing a half hour talk I’m giving next week on that exact subject. I can talk science through and through. But one of the few subjects I’ve never been able to wrap my head around is economics. My brain just doesn’t work.

I want to get a basic idea of how exactly the stock market works. Well, I mean, I get the whole buying and selling and trading stocks thing. It’s more about how companies benefit from stock trading.

So, I get the basic idea of stock. I own SmegCo, a company I set up to manufacture and sell something or other. Because I started it, I own all of it. One day, I decide that I want to raise some money to expand my business and make it way better, so I sell off shares of stock. Each share you own means that you own some small percentage of SmegCo, and SmegCo pays out some part of its profits as dividends to each shareholder. Right so far? I think so.

Now, the value of shares is determined (more or less) by supply and demand. The supply is essentially constant, since I can only sell up to 100% of my company, so demand is what controls the value. The better my company is doing, the more profit it makes, and the higher the dividend, so the more demand there is for shares in SmegCo. So prices go up and down depending on how well my company is doing.

But here’s the part I don’t get. I can see the value to the company in the initial sale of stock - it brings in a lot of money that I can use to make the company better. But it seems that a whole lot of time and effort is spent keeping stock prices high, as an end goal in itself. Once the shares are sold, how does the company benefit from people trading those shares around amongst themselves? If my mom owns 20 shares and sells them to Cecil Adams, does the price of that transaction matter at all to SmegCo? None of the money goes to the company, does it? So why does the company care? You hear a lot of “making the shareholders happy” talk, which I sort of get - they own the company, after all - but why is it such a disaster if share prices tank, for instance? It may affect individuals within the company that own stock as the perceived value of their possessions drops, but it’s not like people are breaking in and stealing money from SmegCo’s accounts…

I’m not sure if my question is clear enough yet, but I’ll throw it out there and see what I get back.

2

Right. Although paying out dividends is not a requirement. Some companies choose not to pay dividends in order to hold onto more of their capital, and companies can change how much they pay in dividends when they feel like it.

The supply is not necessarily constant, since a company can always issue new shares to raise more capital. For example, suppose SmegCo issues 1000 shares initially, and they are currently trading around $100 each (for a total market capitalization of 1000 x $100 = $100,000.) Now they want to raise more capital. They create 200 new shares and sell them for $100 each. Now there are 1200 shares outstanding, and their market cap is $120,000, and they raised $20,000 of new capital. This dilutes the ownership interest of the people who own the original 1000 shares (which is why shareholders must approve this sort of thing) and it also relies on their being someone who is willing to buy the new shares at that price.

A few ways:

  1. It makes employees who get compensated with shares or options happy because their shares are worth more.

  2. It makes it easier to sell additional shares later to raise more capital (see above.) If my stock price is high, I can more easily convince the market to buy new shares of my company.

  3. Companies can borrow money using shares as collateral. The more valuable the shares, the easier it is to borrow.

A precipitous drop can be disastrous if the company has borrowed money against its equity; this happened to Enron, for example. (Among other things.) Lenders demanded that loans secured against Enron shares be repaid once the shares dropped below a certain limit. It also means it’s going to be harder to raise more capital later. For the top executives, it means the board (elected by the shareholders) may fire them. If the value drops extremely low, the company risks being delisted from the exchange, which makes it really hard to raise new capital.

3

One important point is that the pool of stock for a company is not necessarily constant - a company can either issue new stock or do a buy-back.

For issuing new stock, I think a majority of the existing shareholders need to agree - they’re consenting to own a smaller piece of the company, but in exchange for that, the company gets an infusion of capital that it can use to grow. So, depending on the plans for the money being raised by the stock issue, that might be a good idea. It can be combined with a merger, for instance - company A buys out company B in exchange for X many shares of company A to be split among the owners of company B, then all the assets and lines of revenue of B are A’s to draw on.

A buy-back is the reverse - you’re essentially paying shareholders to walk away - the remaining shareholders now hold proportionally more ownership, but the company is poorer for the money it spent on the buy-back.

So that’s one reason it might matter to the managers to keep stock prices healthy - it gives them the opportunity to raise more capital by a stock issue. Another reason is that majority shareholders on the board of directors might give them specific targets for the stock prices (which suggests that they’re interested in selling out,) and would fire the managers if they don’t meet that goal.

Does that help?

waves to friedo on preview.

4

One key issue is that the company can issue more stock, which would presumably be sold somewhere near the current stock price.

Even if the company doesn’t issue more stock, banks know that it’s a possibility, and so they look at the stock price when offering loans to the company. (This is one reason Enron collapsed so spectacularly. A drop in stock price caused banks to call loans due immediately… which further lowered the stock price.)

But also keep in mind that the company is run for the benefit of the shareholders, not the benefit of the company. Shareholders can vote to demand benefits like dividends, and they get a share of the company’s assets when it closes. So… the more profitable a company is, the more shareholders perceive some future benefit will be received, and the more they’re willing to pay for the stock.

Thus, the stock market price does not represent the stock’s benefit to the company; it represents the stock’s benefit to the shareholders. This is probably the more important realization when it comes to answering your question.

5

Buy low. Sell high. That’s the long and short of it.

6

No, that’s the long of it. The ‘short’ of it involves selling high first and betting that you can buy low later, right? :wink:

7

A key point about selling is, you need a buyer. A ‘runner’ delivers the order to the trader who then finds a buyer. It’s important to note because sales don’t always happen the day you issued your order to sell.

8

Can they, in the US? Is there a list of all the things shareholders can/can’t vote on?

9

The company can use shares of itself as collateral? I assume this means that the company owns these shares as it couldn’t use shares owned by outside individuals.

So can a company theoretically own 100% of the shares of itself? And would there be any reason to set up this kind of situation?

10

Isn’t it really more like the opposite? The shareholders own the company so presumably they were the ones who made the decison to have the company buy back their shares. It wasn’t the company that wanted to send away the shareholders - it was the shareholders that wanted to get away from the company.

11

Right.

Well, not 100%. That wouldn’t really make any sense. Some human (or other company) has to have a controlling interest in order to make decisions.

But companies do regularly hold on to shares of themselves (called treasury stock) which is usually the result of a buy-back. They may decide to hold on to the shares (rather than deleting them) so they can resell them at a later date when the price improves, or to borrow against them.

12

Here’s a good general overview of shareholder rights: http://www.enotes.com/business-law-reference/shareholder-rights

As it says, many rights are established by the company’s own bylaws. Even if shareholders can’t vote directly for dividends, they can certainly replace the board of directors until they find people who will issue dividends. Shareholders can also amend the bylaws, dissolve the company, etc. If a majority of shareholders are serious about getting some dividends, they’ll find a way.

13

You’re right in that the price for which your mother sells stock to Cecil doesn’t directly affect SmegCo. But there are three reasons SmegCo’s CEO worries about it. In order from most to least direct impacts:
First is that he may be paid in large part through being given SmegCo stock. So the higher the stock price, the more he gets paid.
Second, is that SmegCo’s CEO is (through the Board of Directors) hired by the stockholders. Obviously, if you are a stockholder, you’re usually happier if the price to be rising and the opposite when it’s falling. Sad stockholders might (again through the Board) decide to fire the CEO and get someone else.
And more fundamentally, the CEO’s theoretical job really is to make money for the stockholders, by both giving them dividends and by making ownership of the company more valuable. It’s easy to count dividends, but how do you decide how valuable a company is? Well, one option, and often the only one, is to see what a bunch of informed people are willing to pay for it. And that’s just the share price. So share price is how a CEO keeps score of how they’re doing.

Now, I think many CEO’s are a little irrationally concerned with very short-term movements of the stock price, but there are lots of ways people pay too much attention to what is being measured instead of the long term goal.

14

In principle, shareholders can vote on almost everything. They can’t vote to have the comp[any disobey a law. Nor can they vote to not live up to a contract. (Obviously they could vote to do either, but there would be consequences.) For the most part, they can’t vote to treat shares unequally; though you can create different classes of shares. So if you owned 51% of the shares you could force the company to declare a dividend, for example. (Though you cold not pay the dividend to just your shares.)

In practice, the shareholders vote for a board of directors to govern the company and the board hires a CEO to run things. Furthermore, in practice, the CEO most often controls who gets on the board. When the company has its annual meeting usually company proposals get 90+% votes and individual shareholder proposals get votes < 10%.

15

Yeah, it’s the same principle, just offset from the start of the sequence. You sell high to buy other things (or the same thing) low. Pretty much all the rest is about how to actually do that.

16

Sorry, I wasn’t clear. I was thinking from the perspective of the remaining shareholders and why they’d find the buy-back in their interest. And I certainly think it might have originated with them, that they wanted a greater share of the company.

After all, if you want to sell shares and ‘get away’ from a company, it doesn’t matter to you if you sell to somebody on the stock market or sell back to the company through a buyback - as long as the price is right!

Related: Can shareholders vote for the company to buyback their shares? I think that could get messy, if the remaining owners of the company don’t want to be left ‘holding the bag’ after the buyback is done. It would make sense to me that the decision would have to be approved by somebody who still holds a stake in the company after the buyback, but I don’t know the details of how that works.

17

This is one of those issues where I would first look to the bylaws. It’s very common to have provisions regarding the sale and transfer of shares in the bylaws, including when approval is needed and from which parties. Without some special provision, my guess is that nothing would stop the buyback from happening like you describe.

The only general principle I can think of is that company actions often have to apply to all shareholders equally. For example, if you want dividends to be issued, then the dividends must be issued to all shareholders (based on stock ownership) and not just to one shareholder. In this case, the company buy-back might have to be an offer available to all shareholders, and not just a special buyback offer for a particular shareholder.

18

Yeah, I was thinking that made sense, though I didn’t mention it because I had enough hypotheticals. And by extension, if every shareholder wants in on the buyback, or enough that the company can’t pay them all, then the buyback can’t happen on those terms.

19

In my limited knowledge of this subject, the only buybacks I’ve seen involved stock that was issued with the buy back provision in place.

20

I’m curious about companies owning shares of themselves. Shareholder equity is a liability against the company; isn’t it a bit like a company owning its own bonds? Seems kind of redundant.